Cold bath for steamy economy

By BRIAN FALLOW economics editor

The Reserve Bank has steeply raised its outlook for interest rates over the next two years, projecting rates a full percentage point higher than it thought would be necessary two months ago.

Acting Governor Dr Rod Carr yesterday raised the official cash rate from 5.25 per cent to 5.5 per cent, as financial markets had expected.

But the accompanying monetary policy statement makes it clear the bank thinks the economy is growing faster than can be sustained and that it will take a couple of years of constrictive interest rates to keep inflation within bounds.

Carr said the economy was growing at an annualised rate of between 3 per cent and 3.5 per cent, probably closer to the latter, and core or potentially persistent inflation was running at around 2.5 per cent and monetary conditions were stimulatory.

"The economy's ability to meet increasing demand without pressure on costs, margins and prices appears limited," he said.

The bank is projecting wholesale 90-day interest rates to hit 7 per cent next year - implying floating mortgage rates of 9 per cent - and stay there all year.

In March, the bank expected 90-day rates to peak around 6.25 per cent in the first half of next year.

The bank's interest rate track implies that the official cash rate, which has been raised 75 basis points this year, will rise a further 100 or 125 points by the middle of next year.

This is a more aggressive outlook than many market economists believe is warranted.

The bank acknowledges several emerging headwinds which will slow the economy, but it does not believe they will be enough on their own:

* The exchange rate has risen sharply. The trade-weighted index is up 6.5 per cent since the start of the year. That would take some of the gloss off an expected pick-up in the world economy, the bank said, just as the previous weakness of the exchange rate limited the local effects of the global downturn last year.

The bank expects the dollar to continue appreciating, by 8 per cent over the nexttwo years. If it climbs faster than expected, interest rates would not have to rise as much.

* Export prices have fallen about 6 per cent over the past year and a similar fall over the year ahead is expected. But the fall was from very high levels, Carr said.

* Household debt levels are at historically high levels, relative to incomes. Although demand for mortgage borrowing has been climbing over the past year, the bank believes households' appetite for additional debt is limited.

The bank predicts growth slowing from 3 per cent over the past March year to 2.25 per cent in the year to March 2005.

But it takes that slowdown, and contractionary interest rates, to keep inflation within the top third of the 0 to 3 per cent target band over that period.

Driving the bank's outlook is the view that the economy's resources are already overstretched and that it will take one to two years to return to a balance between demand and supply.

Strong growth in demand for labour, for example, has been met only because inward migration has been strong and because the workforce participation rate has been pushed to record high levels.

Both will be hard to sustain.

The bank expects the net inflow of migrants to slow later this year as the global slowdown, which may have discouraged would-be emigrants, abates.

Businesses report running at a high level of capacity use but their investment intentions have risen only modestly and imports of capital goods have fallen.

Some analysts queried whether data since the Reserve Bank's last statement in March justified such a pronounced rise in its interest rate projections.

National Bank chief economist Dr John McDermott said it was not the world that had changed so much as the Reserve Bank's view of it.

Forecasts of global growth had improved. But there was uncertainty about that and it would be largely offset by a higher exchange rate, he said.

Growth in the March quarter was strong, but much of it only made up for a weak December quarter.

The bank's view of the output gap (the extent to which output has got ahead of its sustainable, non-inflationary level) is unchanged from two months ago.

Deutsche Bank chief economist Ulf Schoefisch said the Reserve Bank was implying that its view in March was too complacent.

"But they haven't explained the change. You can't see how their thinking has evolved."

In April, the bank had said the data since the March statement had evolved broadly as expected.

"The same can be said for the data flow since April. Nevertheless, the bank has become more concerned about the inflation outlook, which is even more surprising in the light of the significant appreciation of the New Zealand dollar over the past few months," Schoefisch said.

But ANZ chief economist David Drage believes the strength of recent domestic data goes a long way towards explaining the Reserve Bank's darker outlook.

He cites the strength of retail sales and employment figures, and the proportion of firms reporting capacity constraints, skill shortages and an intention to raise their prices.

"I don't necessarily think the bank has turned more hawkish.

"There is a realisation that the risks have shifted more to the upside since March."